2011 July: Under the Microscope

You open the letter from the IRS to find that you are being audited. A shock goes through your body. Fingers begin to shake. The timing couldn’t be worse. You’ve got a business to run. Why you?

Don’t panic. An audit doesn’t necessarily mean there is suspicion that you aren’t being forthright. A portion of all business audits are random selections. Furthermore, an audit doesn’t mean that you will have to pay a large bill. About
25 percent of audits result in dismissal –– you satisfy the auditor and you probably won’t be bothered for many years.

Having said that, there could be cause for alarm. If you are deliberately inflating expenses or under-stating revenue figures, the auditor will seek to discover these untruths. Reducing revenue is considered fraud, and could result in criminal prosecution. Overstating expenses is bad, but one could argue that the books were messed up, the bookkeeper was incompetent, that the computer system malfunctioned, or that you just didn’t understand what was required. In other words, it is easier to make a case for overstating expenses than under-stating income.

The simplest audit is a correspondence audit. This is where you are asked to clarify one or two issues. Responding with a letter that includes backup proof will end the inquiry. Office audits require meeting with an IRS auditor. Most office audits specify areas of concern. Speak to your accountant or CPA. This is the time to speak frankly. Together, evaluate the magnitude of the audit. If it is over a few matters, and your books are in order, you might want to handle the matter yourself. If you prefer, your accountant can represent you. Of course, the accountant will want to be paid. Many preparers start their billing at $150 an hour. Any lawyer, accountant, enrolled agent or un-enrolled agent (tax preparer) can represent you providing he/she did the taxes of that year’s return. “I prefer to do all the talking, although I involve the client a bit to establish credibility,” says long-time audit representative Stuart Campbell of H & R Block in Quincy, Massachusetts.

An audit is always at the convenience of the person being audited. You decide whether you want to meet at the auditor’s office, at home, or at the tax preparer’s office. It mostly depends on how methodical you are.

Organize your records. Make sure you have backup for every figure on your tax return. That means making copies, updating logs, and putting everything in sequential order. If there is no backup, prepare a written explanation of the deduction. If the books aren’t in order, get them in order. This task involves a lot of work, but it will make you knowledgeable about your situation.

Do not go into the meeting like an angry bull. Remember, you’re dealing with a human being. At the same time, do not be a fawning sycophant begging for his mercy. Be professional, business-like. Let the facts and figures do the talking. You’ll go over item by item. The auditor might say that one expense is disallowed. Do not argue. Go on with the proceedings.

Let’s take a few examples. If you have no backup and he says that your deduction is disallowed, come up with an explanation of why there is no backup. For example, you had work done on your storefront, but do not have the receipt because the contractor was disorganized. Argue that you could get the receipt if need be. The auditor might go along since it is a reasonable expenditure.

If your cost of product totals are $1,500 off from the tally, suggest that the difference is cash purchases, where you sent your people out to buy something, or where you personally bought some items and paid cash. Come up with a reasonable explanation.

If you purchased an at-home computer for $1,400 that you say is 100-percent business use, but he argues that computers can’t be solely for business, and will only give you a $700 Section 179 deduction (50 percent of cost), don’t argue. Let the $700 go. That computers can’t be all business use is a rule, and he’s being a stickler. Don’t fight the small potatoes.

Don’t try to outsmart the auditor. Come clean with all major discrepancies up front, especially revenue figures. Most likely, the auditor has the proof in front of him in the form of bank statements.

At the end of the session, he will add up the adjustments and disallowances and come up with an assessment. To that will be tacked on penalties and interest, which could be hefty, because it could be an audit of two years back.

It is possible to counteroffer a compromise figure, which is called an offer in compromise. The auditor will be more inclined to go along if you are close to insolvent. But you never know when he will be willing to bend.

You may challenge the assessment, dealing with an appeals officer, and then you may go to tax court. If there are legal points at stake, you might hire a tax attorney, who might find precedence that could sway the judge. On the other hand, it might be less stressful to swallow hard, pay the bill, and make sure you keep detailed books.

Common Reasons for Audits

Round-numbers. Using round numbers — $8,000 for an oven instead of $7,959 — hints that you are not paying attention to figures.

Big change from last year. If last year’s cost of goods sold was 22 percent and it is 33 percent this year, you need a good explanation of what changed. Auditors look for percentage shifts.

Divergent figures from industry standards. The reason you have to code your business — the six-digit number — is that you are being categorized with fellow operators. Auditors love to do comparisons. If your cost of doing business is much higher than industry average, auditors will want to know why.

High (above the norm) audit scores. The IRS has created a secret list of criteria, including low gross profit margin, high auto expense, high travel and entertainment, and little or no profit. If your overall number is up, you risk being audited.

A messy, hastily assembled return could tip auditors off that you aren’t very thorough. You can’t be disorganized when it comes to the IRS.

Random selection. You were chosen at random.

Howard Scott is a former business owner who has published 1,300 magazine articles and four books.